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Ch10-1

Chapter 10
Corporate Governance
Michael A. Hitt
R. Duane Ireland
Robert E. Hoskisson
©2000 South-Western College Publishing

Ch10-2

Used in corporations to establish order

between the firm’s owners and its top-level
managers
Corporate Governance is a relationship
among stakeholders that is used to determine
and control the strategic direction and
performance of organizations
Concerned with identifying ways to ensure
that strategic decisions are made effectively

Corporate Governance
Ch10-3

Separation of Ownership
and Managerial Control
Basis of the modern corporation
Shareholders purchase stock, becoming
Residual Claimants
Professional managers contract to provide
decision-making
Modern public corporation form leads to
efficient specialization of tasks
- Shareholders reduce risk efficiently by
holding
diversified portfolios
- Risk bearing by shareholders
- Strategy development and decision-making
by
managers

Ch10-4

An agency relationship exists when:

Shareholders
(Principals)
Firm Owners
Managers
(Agents)
Decision
Makers

which creates
Agency Relationship
 Risk Bearing Specialist
(Principal)
Managerial Decision-Making Specialist
(Agent)

Hire
Agency Theory
Ch10-5

The Agency problem occurs when:

- The desires or goals of the principal and
agent conflict
and it is difficult or expensive for the
principal to verify that the agent has
behaved appropriately
Solution: Principals engage in incentive-
based performance contracts, monitoring
mechanisms such as the board of
 directors and enforcement mechanisms
such as the managerial labor market to
mitigate the agency problem

Example: Overdiversification because

increased product diversification leads to
lower employment risk for managers and
greater compensation

Agency Theory
Ch10-6

Example: Boards of Directors have a

fiduciary duty to shareholders to monitor
management

Agency Theory
Principals may engage in monitoring
behavior to assess the activities and
decisions of managers
However, Boards of Directors are often
accused of
being lax in performing this function
However, dispersed shareholding makes it
difficult and and inefficient to monitor
management’s behavior

Ch10-7

Governance Mechanisms
Ownership Concentration
Boards of Directors
Executive Compensation
Multidivisional
Organizational Structure
Market for Corporate Control
 Ch10-8

Governance Mechanisms
Ownership Concentration
Large block shareholders have a strong
incentive to monitor management closely
Their large stakes make it worth their while
to spend time, effort and expense to monitor
closely
They may also obtain Board seats which
enhances their ability to monitor effectively
(although financial institutions are legally
forbidden from directly holding board seats)

Ch10-9

Governance Mechanisms
Board of Directors
Insiders
The firm’s CEO and other top-level
managers

Related Outsiders
Individuals not involved with day-to-day
operations, but who have a relationship with
the company

Outsiders
Individuals who are independent of the
firm’s day-to-day operations and other
relationships

Ch10-10

Recommendations for more effective Board

Governance:

Governance Mechanisms
 Board of Directors
Increase diversity of board members
backgrounds
Strengthen internal management and
accounting control systems
Establish formal processes for evaluation of
the board’s performance

Ch10-11

Governance Mechanisms
Executive Compensation
Salary, Bonuses, Long term incentive
compensation
Executive decisions are complex and non-
routine
Many factors intervene making it difficult to
establish how managerial decisions are
directly responsible for outcomes
In addition, stock ownership (long-term
incentive compensation) makes managers
more susceptible to market changes which
are partially beyond their control
Incentive systems do not guarantee that
managers make the “right” decisions, but
they do increase the likelihood that
managers will do the things for which they
are rewarded

Ch10-12

Governance Mechanisms
Multidivisional
Organizational Structure
Designed to control managerial
opportunism
M-form structure does not necessarily limit
corporate-level managers’ self-serving
actions
Broadly diversified product lines makes it
difficult for
top-level managers to evaluate the strategic
decisions
of divisional managers
Corporate office and Board monitor
managers’ strategic decisions
Increased managerial interest in wealth
maximization
May lead to greater rather than less
diversification

Ch10-13

Governance Mechanisms
 Market for Corporate
Control
Operates when firms face the risk of
takeover when they are operated
inefficiently
Acts as an important source of discipline
over managerial incompetence and waste
Changes in regulations have made hostile
takeovers difficult
Many firms began to operate more
efficiently as a result of the “threat” of
takeover, even though the actual
incidence of hostile takeovers was
relatively small
The 1980s saw active market for
corporate control, largely as a result of
available pools of capital (junk bonds)

Ch10-14
Corporate Governance and
Ethical Behavior
It is important to serve the interests of
multiple stakeholder groups
Shareholders are one important stakeholder
group, which are served by the Board of
Directors
Product market stakeholders (customers,
suppliers and host communities) and
organizational stakeholders (managerial and
non-managerial employees) are also
important stakeholder groups
Although controversial, some believe that
ethically responsible firms should introduce
governance mechanisms which serve all
stakeholders’ interests

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